High Court Guidance on Penalty Doctrine

In the recent case of Honey Bees Preschool Limited v 127 Hobson Street Limited,[1] the High Court has reconsidered the scope of the rule against unenforceable penalties in New Zealand. This is the first case under New Zealand law which has considered the recent re-casting of the penalty test in the United Kingdom[2] and Australia.[3]

Key facts

Honey Bees Preschool Ltd (Honey Bees) runs a childcare facility. It entered into a lease with 127 Hobson for the premises. It also entered into a Deed which required 127 Hobson to install a second lift in the premises. The relevant clause stated that if the second lift was not fully operational by 31 July 2016, 127 Hobson and its director would indemnify Honey Bees for all obligations it may incur to 127 Hobson to the expiry of the lease (the Clause). The lift was installed almost 14 months overdue and Honey Bees sought to enforce the indemnity.

Legal principles

Under traditional legal principles, a fee is an unenforceable penalty if it is payable on breach of a term of a contract; and the payment is extravagant in comparison to the genuine pre-estimate of loss. If a clause had the purpose of deterring a party from breaching, then it was likely to be a penalty. However, recent overseas cases in United Kingdom and Australia have broadened the traditional test as follows:

there may be other broader legitimate interests (apart from loss suffered) that are relevant to whether a clause is a penalty; and

the fact that a clause is designed to deter a party from breaching, does not mean that it is necessarily a penalty.

In addition, the Australian and United Kingdom courts have disagreed on whether the penalty doctrine only applies where a sum is payable on breach of contract. The Supreme Court in the United Kingdom has said that a breach of contract is necessary and that a penalty only exists where a secondary obligation is imposed to compensate for breach of a primary obligation.[4] In contrast, the High Court of Australia has said that a breach is not necessary and that a primary obligation can be a penalty. The Australian position was discussed recently by the New Zealand Court of Appeal in the Torchlight case – see our case summary here.

Decision of the High Court

The Court found that “[t]he central issue is whether a stipulated remedy for breach is out of all proportion to the legitimate performance interests of the innocent party, or otherwise exorbitant or unconscionable”. The key factors in assessing whether a clause is an unenforceable penalty are:

Whether the parties were commercially astute, had similar bargaining power and were independently advised.

Whether the main purpose of the clause is to punish, as opposed to simply deter non-performance.

A comparison between likely loss and the stipulated sum (as in the case of a liquidated damages clause).

In relation to whether the penalty doctrine applied to secondary obligations only or both primary and secondary obligations, the Court did not rule on the question finally. However, the Court preferred that the doctrine would only apply to secondary obligations where the secondary obligation is triggered by a breach of a primary obligation.

Outcome

Justice Whata found that the penalty rule was engaged but that the indemnity was not an unenforceable penalty. The indemnity was not out of proportion to Honey Bees’ legitimate interests in the performance of the obligation because:

Honey Bees had a legitimate interest in the installation of a second lift within a specified time.

127 Hobson had 31 months to install the lift, which was ample time.

The parties were commercially astute and the landlord should have known the second lift was important as it could affect Honey Bees’ ability to operate the facility at full capacity. The indemnity merely shifted the risk to 127 Hobson.

The likely loss arising from delay in installing the lift was not quantifiable at the time of execution.

The main purpose was not to punish non-performance. Due to other events, Honey Bees had good reason to doubt the reliability of 127 Hobson’s ability to install the lift in time.

Our view

This provides helpful clarity on the New Zealand law on penalties given the recent divergence between Australia and the UK. The decision makes it clear that broader legitimate interests are relevant and that the question is not simply whether the compensation is a genuine pre-estimate of loss. There is also some additional comfort for those drafting contracts:

The Court’s initial view (which will need to be finally determined) that the penalty doctrine only applies where a sum is payable on breach of a contractual term, provides an indication regarding the likely ambit of the doctrine.

Where commercial parties of equal bargaining power are involved, the risk that a clause will be held to be a penalty is reduced.

Despite those reassurances, those drafting contracts should continue to take care to ensure there is a legitimate interest which a payment obligation on breach is seeking to protect and the sum payable is proportionate. If you have any questions in relation to this article or penalties in general please contact our experts.